International rating agency Fitch says Sri Lanka's budget for 2018 sticks broadly to the targets for fiscal deficit reduction under its 3-year IMF programme, which began in June 2016.

However, high government debt and the large cost of debt servicing weigh heavily on Sri Lanka's credit profile and will require sustained fiscal consolidation over the long term, said Fitch Ratings.

The recently announced budget targets a fiscal deficit of 4.8% of GDP in 2018, which is only slightly above the 4.7% target agreed with the IMF and continues the consolidation that began in 2016.

Floods and drought weighed on the economy and public finances during 2017 and contributed to the government missing its initial 2017 fiscal deficit target of 4.6% of GDP.

Fitch added, “Nevertheless, the authorities still expect the 2017 deficit outturn to fall to 5.2% of GDP, from 5.4% in 2016”.

Consolidation in 2017 has been driven by measures to boost tax revenue, including a hike in the value-added tax (VAT) to 15% in November 2016 from 11%.

The government expects revenue to rise strongly again in 2018, to 15.7% of GDP, from 14.7% in 2017.

Revenue should be supported by an Inland Revenue Act passed in September 2016, provided implementation is effective. The act, which will come into effect from 1 April 2018, aims to simplify the tax laws and improve the efficiency of the system.

Despite these positive reforms, Fitch said they see downside risks to the government's revenue projections, given a GDP growth assumption of 5%-6% for next year, compared with Fitch’s assumption of 4.5%.

On the expenditure side, the government expects public investment spending to rise by 20% in 2018, while recurring spending is forecast to decline.

Interest payments are expected to account for more than one-third of total revenue, which is a key weakness in the fiscal profile.

Fitch also said Sri Lanka faces a challenging external debt service schedule in the near term, with very large external debt maturities coming up over 2019-22.